CBSE Class XII Accounts Fundamental Concepts

 

 

Chapter 2

Partnership Accounts - Reconstitution by Changing Ratios

 

 

A partnership business may undergo several structural changes during its lifetime. When the existing partners of a firm decide to reconstitute their business by changing their profit sharing ratio, it becomes essential to make appropriate accounting steps. Reconstitution of partnership can take place as a result of decision by the partners to change their profit sharing ratio, or by way of admission of a new partner, retirement of a partner or by death of a partner. The following are the essential aspects to be considered on reconstitution of the partnership among existing partners.

 

1. Change in profit sharing ratio among existing partners; sacrificing ratio and gaining ratio

2. Distribution of reserves and accumulated profits

3. Revaluation of assets and liabilities

4. Treatment of goodwill

5. Readjustment of capital accounts

 

 

1. Change in Profit Sharing Ratio among existing partners - Sacrificing Ratio and Gaining Ratio

Existing partners may decide to change their profit sharing ratio for various reasons. When the profit sharing ratio is revised among existing partners, there ought to be a partial sacrifice of profit share by some partners in favour of others. The sacrifice of one or a group of partners becomes the gain of the remaining partners. When the profit sharing ratio is revised it is important to calculate the sacrificing ratio and gaining ratio. These ratios are required to adjust the value of goodwill of a firm without raising goodwill account in the books. Sacrifice / gain ratios can be applied to adjust the profit or loss on revaluation of assets and liabilities in the capital accounts of partners without actually changing the values of those assets and liabilities.

 

 

Method of calculating sacrificing ratio and gaining ratio

Sacrificing ratio in partnership accounting is the ratio in which existing partners sacrifice their share of profit. This happens due to a revision in profit sharing ratio or admission of a new partner. This is calculated by deducting the new ratio from the old. When there is sacrifice new ratio is always lower than the old.

Gaining ratio is the opposite of sacrificing ratio. This is the ratio gain to the existing partners of a firm when they revise the profit sharing ratio, or when the profit share of the deceased or retired partner is shared by the other partners. This ratio is calculated by deducting the old ratio from the new ratio. The new share will be higher than the old when there is a gain.

 

Shortcut to calculate sacrificing ratio and gaining ratio

When there is a revision of profit sharing ratio by existing partners, there will be sacrifice as well as gain within the same partnership. Therefore it is easier to stick to one formula. Take the result of new ratio minus old ratio. If the result is negative it is sacrifice; and positive it is gain.

 

Notice the steps once again:

1. Write the new ratio in the first line

2. Write the old ratio in the second line (remember to adjust the ratios to add up to the a convenient total)

3. Deduct the old from new

4. Negatives result indicates sacrifice; positive result indicates gain

 

2. Revaluation of Assets and Liabilities

Assets and liabilities are often shown in the accounts at their historical value rather than realisable value. Due to conservatism the partners usually do not revise the values of assets even when their actual market values are much higher than book values. Similarly inadequate depreciation, change in technology etc. make the book values of certain assets more than their realisable value. It is not practical for the partners to keep on changing the book values of their assets according to their market values. The difference between book value and market value is not a problem as long as the partnership business goes on normally. But when they change the structure of the partnership in the form of revision in profit sharing ratio, admission of a new partner, retirement or death of a partner, amalgamation of two partnership firms, absorption of a firm by another etc., the values of assets and liabilities are to be reassessed and difference if any, should be accounted.

 

What is the purpose of revaluation?

When the realisable value of asset or liability is different from the book value there is a profit or loss is hidden in the difference in value. The partners are entitled to all the profits and loss in the existing profit sharing ratio. If the ratio remains unchanged there is practically no use in estimating the hidden profit or loss. However, if the partners want to change the profit sharing ratio, this hidden profit or loss should be distributed first before changing the ratio. If this profit or loss is not distributed prior to changing profit sharing ratio some partners are likely to lose and others gain due to the change in ratio.

 

For example: A&B, who were equal partners purchased land for Rs.10,000 in Jan 1975. They decided to share profits and losses in the ratio 2:1 from 1^st January 2001. The market value of land on 1^st January stood at Rs.70,000; whereas the book value remains at the purchase price of Rs.10,000. There is a hidden profit of Rs.60,000 in the value of land which A & B entitled to share Rs.30,000 each. Suppose they ignored this factor and changed the profit sharing ratio to 2:1 and sold the land for Rs.70,000 afterwards, the profit on sale of land Rs.60,000 will go to A and B in the new ratio 2:1, which means A will get 40,000 and B will get only 20,000. In other words Rs.10,000 belonging to B will wrongfully go to A. Vice versa can happen in case of a hidden loss. To prevent such problems the partners revalue the assets and liabilities and transfer the net result into their capital accounts in the existing ratio before making a change.

 

 Revaluation Account

When the value of one asset is to be increased in the books it can be easily done by debiting the asset and crediting it to partners’ capital accounts in the profit sharing ratio. But when there is a major shake up, values of almost every asset and liabilities are to be revised. For the purpose of convenience, revised values of assets and liabilities are brought into books by opening a temporary account called ‘revaluation account’. The revaluation account summarises the effect of revaluation of assets and liabilities.

 

Revaluation account is a special profit & loss account representing the combined capital accounts of partners. Any gain on revaluation of asset or liabilities, which are to be credited to partners, will be credited in the revaluation account. Similarly any loss on revaluation will be debited in revaluation account instead of debiting the capital accounts. The final balance in revaluation account indicates the profit or loss on the entire revaluation process. The revaluation account is closed by transferring this profit or loss to partner’s capital accounts in the ratio before revision (old profit sharing ratio). All assets and liabilities will appear at their revised values in the books and in all future balance sheets.

 

When the partners want to adjust the profit or loss on revaluation process without actually changing the values of assets and liabilities in the books they can do so by opening a memorandum revaluation account. This revaluation account has two parts. The first part is a normal revaluation account and the profit or loss on this part is transferred in the old profit sharing ratio. The second part of memorandum revaluation account is almost a mirror image of the first part. Whatever debited in the first section is credited in the second and whatever credited is debited. Naturally if there was profit in the first section, there will be loss in the second and vice versa. The profit or loss in the first part is transferred to capital accounts in the old ratio, and that at the second part will be transferred to capital accounts new profit sharing ratio. As a result of this exercise the effect of profit or loss on revaluation will be fairly embedded in the capital accounts of partners.

 

3. Distribution of Reserves and Accumulated Profits

Distribution of reserves and accumulated profits is the first step in any reorganisation process. They include general reserves, credit balance in P & L accounts or any other fund that are retained in the business. These are profits earned in the past, but not taken out by the partners, or profits kept aside. Therefore, when the partners decide to change their future profit sharing ratio, the past profits retained in the above accounts should be distributed to partners in the old ratio as a first step.

Nature of Goodwill

1.      Goodwill is an intangible asset

2.      Goodwill is a valuable asset.

3.      Goodwill generates extra income for the business

4.      It is acquired in a gradual process

 

Following are the major situations in which the goodwill of the firm is to be estimated.

a. Change in profit sharing ratio

b. Admission of a new partner

c. Retirement or death of a partner

d. Amalgamation of two partnership firms

e. Absorption of a firm by another one

 

Factors Influencing Goodwill

There are several factors that influence the formation of goodwill. The following are some of the important factors helping the formation of goodwill in a business.

1. Honest business dealings

A firm builds up its reputation over a long period by consistent good dealing with the customers. Once the customers start identifying a business for clean and honest dealings they would prefer to stay with the firm, which in turn help the firm to earn higher profits.

 

2. Good quality of products

A manufacturing concern maintaining a very good quality in their production will gradually build up reputation, which will help them while launching new products. Similarly trading concerns dealing only in good quality products will gradually build up their reputation.

 

3. Ideal Location

Good location of the business is another favourable factor enhancing the profitability and thereby goodwill of the business. A business which is centrally located will naturally attract more business and more profit.

 

4. Special skill or Technical Know-how

The business builds up skill in dealing with their product line, dealing with the clients’ specific requirements, problems associated with the geographical location of their business etc. through experience. The problems are wide and varied, and solutions are also equally diverse. Thus the actual experience help develop skill in dealing with similar situations in future, which is naturally promote efficiency and goodwill of the business.

 

5. Monopoly of Business

Some established business concerns manage to build up their monopoly simply by being the first one in the market. This enables them to establish its position in and to some extent, restrict future competition. Even though, monopolies are undesirable from the customer’s point of view, they are unavoidable and harmless at a limited scale.

 

Methods of Valuation of Goodwill

Following are the most common methods adopted for valuation of Goodwill.

a.   Average Profit Method

Average profit method, as the name suggests, is based on the average profit of the business. Under this method, average profits for the  past three or four years as agreed by the partners will be taken. Goodwill is estimated as twice or thrice of this average profit.

 

b.   Super Profit Method

The existence of Goodwill is recognised in a firm only when its profitability is beyond the level of a new firm. Such excess profit earned by the firm is termed as super profit.

 

c.    Capitalisation Method (Goodwill based on Capital Saved)

Capitalization method considers goodwill as the value of capital saved due to higher profitability. Under this method the amount of effective capital is estimated on the basis of market condition. This effective capital is always higher than the actual capital due to better profitability. The excess of effective capital over the actual capital is regarded as capital saved which is considered the goodwill of the firm. Capitalization of super profit and capitalization of actual profit and estimation of capital saved as goodwill are practically the same.

 

Accounting Treatment of Goodwill

Once the value of goodwill is estimated it should be properly accounted prior to readjustment of profit sharing ratio. There are basically three methods of treatment of goodwill which are:

 

Margin Adjustment Method

Revaluation Method (discarded by CBSE)

Memorandum Revaluation Method (discarded by CBSE)

 

Margin Adjustment Method

This method is used when the partners do not want the goodwill account to appear in the books and to adjust the goodwill only through the capital accounts. When profit sharing ratio is changed what actually happens is something is added or deducted from their old profit share. In other words they retain a major part of their old profit share for which no adjustment is required. Goodwill under this method is adjusted on the basis of marginal increase or decrease of goodwill. The basic rule is that the gaining partner shall compensate the sacrificing partner.

 

Following are the steps involved in goodwill adjustment.

 

i)                    Find out the partner’s sacrifice / gain

ii)                  Debit gaining partner and credit the sacrificing partner with the proportionate value of goodwill.

 

If you find the ratios bit difficult, you can arrive at the margin values by following memorandum revaluation in a different format in the workings. This is basically crediting full value of goodwill to partners’ capital accounts in the old ratio and debiting it in the new ratio. The net result is premium being adjusted in the account. You are not allowed to show these entries in the capital account. But the examiner has no problem if you do it in the workings. I followed this method in all illustrations in "Concise Accountancy"

 

5. Adjustment of Capital Accounts

When the partners change their profit sharing ratio, they may also change their capitals. Contribution of capital is not essentially the basis of profit sharing. But in most cases capital contribution is considered the most important factor in determining profit sharing ratio. Capital balances are usually adjusted by bringing in or taking out cash. However as a temporary measure capital balances can be adjusted by transferring the differences through current accounts.

 

 

 Theory Questions

 

1.      What is goodwill?

 

2.      State any four factors which influence the valuation of goodwill

 

3.      On what occasions does the need for valuation of goodwill arise?

 

4.      What are the different methods of valuation of goodwill?

 

5.      Distinguish between ‘average profit’ and ‘super profit’ methods of goodwill.

 

6.      Explain the revaluation method of treatment of goodwill.

 

7.      What is sacrificing ratio?

 

8.      Give two circumstances in which sacrificing ratio must be applied.

 

9.      Why is there a need for revaluation of assets and liabilities of a firm, if there is a change in profit sharing ratio?

 

10.  Distinguish between Revaluation Account and Memorandum Revaluation Account.

 

11.  Explain various accounting steps involved in the in the reconstitution among existing partners.